5 questions about passive investing

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5 questions about passive investing

Though not as popular in India, as it is in the U.S., it is getting noticed. Here are a five questions investors need to get answered before they consider passive investing with regards to the stock market.

1) How is passive investing different from active investing?

Actively managed funds are those where the fund manager decides which stocks to buy and when to buy or sell them. It also means that the fund manager tactically manages the portfolio. So when he sees upside in a sector, he may move into that or exit it altogether if he is of the opinion it could crash.

Since the aim of active management is to deliver a return superior to the benchmark, an actively managed fund offers the potential for much higher returns than the benchmark, providing the fund manager gets his calls right. If not, the downside could be much higher too.

In the case of passive investing, the fund simply tracks the benchmark. It invests in the identical sectors and stocks in the similar allocations of those of the benchmark.

2) What makes an index fund different?

In its simplest sense, an index fund is a fund that attempts to replicate the performance of a given index by duplicating its composition. Most index funds work by identifying an already well-known index, then building a fund that either owns every asset in the index or achieves the same end by holding similar securities.

For instance, HDFC Index Nifty tracks the Nifty and the portfolio consists of the 50 stocks that comprise the Nifty. While HDFC Index Sensex tracks the Sensex and its portfolio comprises of the 30 Sensex stocks. On the other hand, HDFC Index Sensex Plus aims at investing 80-90% of the net assets into stocks which comprise the Sensex, while the balance is left to the discretion of the fund manager.

A regular fund on the other hand will have the fund manager researching and picking stocks he believes have great upside. He will not restrict himself to the universe of the benchmark stocks, as in the case of an index fund.

3) Who is an index fund targeted at?

An index fund is targeted at first-time investors – those who are investing in funds for the first time and have no idea as to how other funds are positioned and how to select one from the hundreds available.

They are also targeted at those investors who are unconcerned with the relative performance of one company over another in terms of its stock price, and with beating the market in general. They are for investors who want to participate in the stock market, but don't want their investment to dip below market returns. Hence they buy a fund that moves in accordance with the benchmark.

This is also for investors who want a low-cost exposure to the stock market. To use the earlier examples, the expense ratios of HDFC Index Nifty and HDFC Index Sensex are 0.56% and 0.49%, respectively. It goes up to 1.06% in the case of HDFC Index Sensex Plus to account for some amount of active investment. In the case of pure active funds, the expense ratio can go up to 2.50%.

Finally, investing in a fund like the above which will offer exposure to large-cap stocks, can be a good core holding for a portfolio.

4) What is tracking error?

Tracking error is a measurement of how much the return on a portfolio deviates from the return on its benchmark index.

Not all index funds are identical. Some track their benchmarks more closely than others. The amount by which a fund veers from the performance of the index it is trying to match is known as tracking error. For example, if an index gained 3% over a year, while a fund that tracks it gained 2.7%, the tracking error is 0.3% over that period.

The tracking error exists due to trading and management costs. It is all the more heightened when a fund doesn't hold all of the securities in its benchmark. Then research and trading costs increase the expense ratio, which impacts the tracking error.

The lesser the tracking error, the more accurate the index fund.

5) How does an index fund differ from an ETF?

An exchange traded fund, or ETF, is a type of fund which owns the underlying assets (stocks or gold) and divides ownership of those assets into shares. For example, a Gold ETF will buy actual gold. It is for this reason that it serves as a proxy to investing in gold. Or, for instance, iShares, the world's largest ETF provider, has an ETF called iShares S&P India Nifty 50 Index Fund, which tracks the S&P CNX Nifty Index.

In the case of an index fund, you can buy the units from the asset management company, or AMC, and sell them back to the AMC, based on the current net asset value, or NAV. In the case of an ETF, the units are listed and traded on the stock exchange. Which means that investors need to have a demat account to buy and sell ETFs. Unlike an index fund where the NAV is declared end of the day, an ETF could experience price changes throughout the day, depending on demand for the product.